Dollar falls after Fed interest-rate decision

Fed sees 'substantial cooling' of housing; inflation risks

By

WanfengZhou

NEW YORK (MarketWatch) -- The dollar fell against the euro and traded little changed versus the yen Tuesday, reversing early gains after the Federal Open Market Committee held its benchmark federal funds rate unchanged at 5.25% and downgraded its assessment of the housing sector.

The Fed's accompanying statement said that "some inflation risks remain" and that the cooling in the housing market has been "substantial." The Fed also noted that it expects a moderate pace of growth "on balance" in coming quarters, although "recent indicators have been mixed." See full story.

The mention of "substantial" and "mixed" was interpreted "as somewhat less hawkish" as it may fuel expectations "that the Fed will be ready to deliver a rate cut on any evidence of moderating inflation," said Sue Trinh, senior currency strategist at RBC Capital Markets.

Late in New York, the dollar was quoted at 116.76 yen, compared with 116.96 yen late Monday. The euro changed hands at $1.3277, vs. $1.3238.

The British pound traded at $1.9703, up from $1.9565. The dollar changed hands at 1.1996 Swiss francs, compared with 1.2025 francs.

Marc Chandler, global head of currency strategy at Brown Brothers Harriman, said the details of the Fed's statement "were mildly more dovish" than the October one. "Overall, those comments give a sense that committee members are a bit more equivocal about the growth outlook" and that "has reinforced our dollar selling bias."

The odds of an interest rate cut by the end of the first quarter remained unchanged after the Fed's interest-rate announcement. Traders were pricing in a 28% chance that the Fed will lower its target for overnight rates to 5% from 5.25% in March.

Trade gap shrinks sharply

The dollar had earlier risen after a government report showed the U.S. trade deficit narrowed to its smallest level since August 2005 in October. The Commerce Department said the trade deficit narrowed by 8.4% in October to $58.9 billion, well below the consensus forecast of economists surveyed by MarketWatch of a deficit of $63.1 billion. The narrowing of the deficit was the largest since December 2001. See full story.

On Monday, the dollar took a hit after former Federal Reserve Chairman Alan Greenspan warned that dollar weakness could continue "for a few years" and that it would be imprudent to "hold everything in one currency."

David Brown, an economist at Bear Stearns, noted that "cyclical" weakness coming from fears over the U.S. economy and speculation that the Fed will have to ease, and "structural" weakness associated with the "apparent demise of the dollar as an international currency" are likely to weigh on the U.S. currency in the future.

German sentiment

Meanwhile, the euro rose after data showed the ZEW indicator of economic sentiment in Germany rebounded to minus-19 in December from minus-28.5 in November. Economists were expecting a reading of minus-25 in December. The data reinforced the view that the euro zone's largest economy remains on track for a robust performance.

The ZEW said that the sentiment rise might be due to the fact that the recent economic upswing is gaining momentum. A total of 303 analysts and institutional investors participated in this month's ZEW Financial Markets Survey.

Elsewhere, the British pound rallied after a surprisingly strong increase in consumer price inflation boosted expectations the Bank of England would lift interest rates early next year. U.K. CPI rose 2.7% year-on-year in November, above consensus forecasts for a 2.6% gain. This is the highest inflation rate in a decade. Core CPI increased by 1.6% from a year earlier.

The acceleration in U.K. inflation "raises the risk that [The Bank of England] will hike rates again in early 2007," said Bear Stearn's Brown. It'll "provide a lift for the pound on further rate hike fears. A test of $2.00 is still on the cards for sterling quite soon."

Not healthy for yen

The yen remained under heavy pressure, hitting fresh record lows versus the euro, after recent soft economic data and news reports dampened expectations the Bank of Japan would raise interest rates next week.

Japanese November corporate goods price index fell 0.1% in November for a year-over-year rate of 2.7%, down from 2.8% in the previous month. Traders await the release of a key Tankan business-sentiment survey on Friday for more clues to the interest-rate outlook in Japan.

Ian Copsey, senior analyst at Global Forex Trading, said "what is becoming apparent is that the gains seen over the past year or two may well have been oil-price-driven rather than on domestic growth."

"With only a small likelihood of any meaningful increase in CPI over the coming months, the risk is for the next rate hike to be delayed, which will not be healthy for the yen," Copsey said.

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